Raising capital: The ins and outs of late-stage finance from a legal expert

Your earlier pitch was all about potential, but now you’re in the late-stage finance arena, it’s time to focus on performance.

As a founder of a late-stage startup, you’ll be used to making key decisions to grow your business. At this stage, it’s likely you’ve got your basic business structure bedded in – sales, marketing, fulfilment and support. The uncertainty of your business success has diminished, but your capital needs have never been greater. Fortunately, the more stable your business becomes, the more financing options you’ll have available to you.

The question is, what’s the best way to expand your business at this stage? Do you need to go public to raise the necessary funds, or are there other opportunities to finance your ambition?

Sophie Mao, a practice leader with the venture capital team at LegalVision, advises on the legal and corporate governance perspective of these questions for clients every day. She recently shared her key considerations for anyone setting up late-stage finance at Startup Daily’s From Idea to Unicorn event series. Here’s what she wants you to focus on.

Before you raise

Work out the best way to structure the deal

“To begin with, one of the first considerations is how you’re actually going to raise money and how you’re going to structure the deal,” said Mao. “So people often think about late-stage financings as being equity rounds. However, it is still quite common for mature startups to do bridging rounds using SAFEs or convertible notes.”

Priced equity rounds

Priced equity rounds can take a long time to negotiate, leaving you without sufficient cash. Sometimes they take so long that the value of your business has increased to the point that you have to renegotiate your share price all over again.

Convertible notes

Instead of offering shares to the investors, you offer a convertible note, which is effectively a fixed-term loan to the company. At the end of the term, your investors can choose whether they’d prefer to have their principal back plus interest, or whether they would rather the loan be converted to shares in your company.

SAFEs

SAFE stands for “Simple Agreement for Future Equity”, and it’s a form of convertible security. In exchange for their money, your investor receives the right to purchase stock in a future equity round, subject to certain parameters set out in the SAFE.

Though they each have their setbacks, convertible notes and SAFEs will both help you raise money faster, so they are worth looking into.

Venture debt

This is the other type of funding available in a late-stage finance round. Venture debt takes the form of a term loan, a facility, or a revenue loan.

“Venture debt isn’t something that is really an option for early stage companies,” said Mao. “You wouldn’t have achieved the consistent cash flow required to demonstrate to a venture debt lender that you can service the loan. But it could be a good option for a later-stage company, because the higher interest rate, and lender fees might still be cheaper than giving away equity.”

You also limit the upfront dilution involved with doing an equity round.

There are three main types of venture debt structuring:

1. Term loan – this is similar to a traditional bank loan in that by the end of the set term, you need to have repaid the principal and accrued interest in full.
2. Revolving credit facility – this operates similar to a credit card.
3. Revenue loan – a hybrid between debt and equity, rather than requiring fixed interest payments, repayments are tied to the borrower’s turnover.

Consider your shareholder numbers

As your company grows, new financing solutions may mean you risk going above the 50 shareholder cap for private companies.

“Consider whether it’s appropriate to implement certain structures to manage that number,” advised Mao. “[One example is] rolling your smaller investors into some kind of bear trust structure, where the underlying investors still get the benefit of their shares, but there’s just a single corporate trustee recorded on the company’s share register.”

Protect the rights of your investors

It’s important to prioritise the rights of major investors and consider limiting the ability for minority shareholders to slow down or hinder your ability to get things done.

“In the early days, it might not have been very burdensome to treat all investors equally in relation to things like reporting requirements and pre-emptive rights on future capital raisers,” Mao noted. “But as the number of investors grows, it could be a hindrance actually, and a large administrative burden in relation to closing a deal, if you do have minority shareholders that are very slow or potentially just completely unresponsive.”

Secondary sale participation

If there is high investor interest and the round is oversubscribed, there may be an opportunity for third-party investors to purchase shares off existing shareholders.

“As a founder, this might be a really good opportunity for you to finally take some cash off the table after working very hard in making a lot of sacrifices for a long time,” said Mao.

Generally, investors are happy to consent to structuring the deal to include a secondary element if it makes sense for the company and for the founders.

Doing the deal

Know your liquidation preferences

A liquidation preference is a clause in a contract that dictates who gets paid first in the event your company goes under.

“As you grow and do a few rounds of capital raising, you might end up with several different classes of preference shares,” Mao explained. “This means that one of the key terms to negotiate in a new round is whether the new preference shares will rank equally with the preference shares of your existing investors or superior to them.”

Many startups support equal ranking preference shares as a matter of principal because they like that investors are all treated equally. However, this will be a matter of weighing up the risk attached to your early-stage investors coming on board when your startup was less stable, with the risk attached to late-stage investors most likely putting in more money.

“From a founder’s perspective, this might not be something that you feel too strongly about either way, because unfortunately, if the company goes bust, you’re probably not going to get much money at the end of the day anyway,” noted Mao. But at the same time, your existing investors will need to consent to any liquidation preferences in new finance contracts, because it will vary their existing rights.

Build in anti-dilution rights

Anti-dilution rights are built into convertible preferred stocks to help shield investors from their investment potentially losing value. For example, if an investor buys shares at $10, and a later round sells for $5, then the initial investor will be issued with more shares to adjust to the new price. It’s not quite that simple, though.

“In Australia, they’re nearly always called broad-based weighted average anti-dilution rights,” said Mao. “Which means that investors don’t get the full adjustment of that lower share price that’s involved in that down round, but they will get the benefit of a price that’s somewhere in between the price that they paid and the price of the down round.

“As you grow and undertake different financing rounds, you should be mindful of how these anti-dilution rights interact with any other interests that you have in place within the company.”

Factor in forced exit provisions

Another consideration when you’re doing the deal is to factor in forced exit provisions. They are becoming more common in late-stage finance and terms can vary quite widely.

“It could be as simple as requiring the company to consider what their options are in good faith,” said Mao. “Or it could go as far as allowing the lead investor to force the company to undertake an exit based on advice that they’ve received from an advisor that they’ve put in place and a purchaser that they find.”

After the deal is done

Be mindful of new financial reporting obligations

Many startups who raise larger late-stage finance rounds will deal with Australian funds who are early-stage venture capital limited partnerships, or ESVCLPs. These are a type of fund that can be very tax-effective and attractive for investors, but they are heavily regulated. Some of those regulations will impact the way you manage your company.

“In particular, one of the requirements is that if a company’s total asset value is more than $12.5 million, they have to have a registered auditor and be preparing audited financial accounts,” advised Mao. “This can be expensive compared to what some companies are used to, but it can be a great opportunity to mature the company’s reporting practices, get its affairs in order, and identify any issues in the company’s financial and tax history and fix those up to avoid any nasty surprises, say when you get to an exit.”

Consider the structure of ESOP offers

Mao’s final consideration for late-stage finance agreements was around the structure of ESOP (Employee Share Option Plan) offers.

“Most startups in Australia utilise what’s called the startup concessional rules for its ESOP and in making its ESOP offers to enable its employees to get tax concessions in connection with their equity,” she explained. “One of the requirements under those rules is that an offer of options has to have an exercise price, which is at least equal to the market value of the company’s ordinary shares at the time of the offer.”

You’ll have to either rely on the share price of your most recent round, or get a formal valuation to determine what the market value is of your ordinary shares.

“That means your employees will likely have to be paying a lot more for their equity than they otherwise would have before that,” warned Mao. This is a natural consequence of your company’s growth and value, but it’s something you will want your valuable employees to be comfortable with.

For more info on Sophie Mao and LegalVision, head to legalvision.com.au

Watch Sophie’s From Idea to Unicorn session here:

Idea to Unicorn

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This article is brought to you by Startup Daily in partnership with LegalVision.

Feature image: Sophie Mao, LegalVision